THE ASSOCIATION BETWEEN CHANGES IN CLIENT FIRM AGENCY COSTS AND AUDITOR SWITCHING

Researchers have posited that auditors specialize in the level of audit "quality" provided to clients. "Quality" is defined as the probability that the auditor will both detect and report material breaches in the accounting system. Differing quality levels are demanded by clients based upon how closely management's incentives align with those of the company's owners. The disparity between management and owner incentives results in agency conflicts. The extent of these agency conflicts determines the degree of auditing needed to make management credible to current and potential investors. Specifically, the higher (lower) the extent of the agency conflicts, the higher (lower) the demand for audit quality. This study explores this relationship by examining 131 auditor changes for an association between changes in auditor quality and changes in agency conflicts around the time of the auditor change. The statistical technique of principal components analysis is used to model changes in auditor quality as a combination of auditor size, name-brand, industry expertise, and independence. Agency conflicts are proxied by leverage, management ownership, and size of short-term accruals. Changes in agency conflicts are measured over a period spanning two years before the auditor change through two years after, whereas previous research focused on a single point in time. The results provide support for the hypothesis that changes in management ownership and leverage are associated with changes in audit quality, independently of changes in firm growth and securities issues. The associations also reveal that managers seem to change auditors in anticipation of some agency conflicts and in reaction to others. In addition, the name-brand surrogate yields qualitatively identical results to more complex measures that combine multiple surrogates.